Mortgage Meltdown

It's Back - Now Federal Reserve To Purchase $600 Billion In Troubled Assets

The government's purchase of troubled assets is back, although the assets will not be purchased under the TARP program.  In an announcement earlier this morning, the Federal Reserve stated that it will be purchasing up to $600 billion in mortgage backed assets, primarily from the government sponsored entities, Fannie Mae and Freddie Mac.  Apparently, the Federal Reserve had the authority to purchase troubled assets all along, which makes the drama about the passage of the EESA, with its original focus on troubled assets seem strange.  The Deal Professor blog, associated with the New York Times Dealbook, noted yesterday in a post about the second Citi bailout that the government had this authority all along and that the Treasury's response to the credit crisis is "government by deal."  You can read the post here.

The announcement comes a week after Treasury Secretary Paulson announced that he would not use the $700 billion in TARP funds under the EESA to purchase troubled mortgage-backed assets, instead focusing on direct capital infusions into financial institutions.

Here is the full Federal Reserve press release:

The Federal Reserve announced on Tuesday that it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises (GSEs)--Fannie Mae, Freddie Mac, and the Federal Home Loan Banks--and mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae.  Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late.  This action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.

Purchases of up to $100 billion in GSE direct obligations under the program will be conducted with the Federal Reserve's primary dealers through a series of competitive auctions and will begin next week.  Purchases of up to $500 billion in MBS will be conducted by asset managers selected via a competitive process with a goal of beginning these purchases before year-end.  Purchases of both direct obligations and MBS are expected to take place over several quarters.  Further information regarding the operational details of this program will be provided after consultation with market participants.

A Second Bailout For Citigroup

This morning the U.S. Treasury Department and Citigroup announced a new bailout for Citigroup, including a guarantee against losses on mortgage backed assets and an additional $20 billion equity investment by the government (on top of the $25 billion in preferred stock already purchased by the government).  Treasury's joint statement with the FDIC and the Federal Reserve is available here, and the Citi press release is available here.

The deal between the government and Citi involves a number of facets.  The first aspect is similar to the original purpose of the TARP program -- the government will guarantee "against the possibility of unusually large losses" (as characterized by the Treasury statement) on a $306 billion pool of mortgage backed assets (loan and securities) held by Citi.  The assets will remain on Citi's balance sheet, and Citi will retain any income streams from the assets.

The term sheet posted on Citi's website states that Citi will be responsible for the first $29 billion in losses (in addition to any existing reserves on Citi's balance sheet) on the portfolio on a pre-tax basis.  After that, losses will be allocated 90% to the government and 10% to Citi.  The first $5 billion in losses assumed by the government will come from TARP funds.  The second $10 billion comes from the FDIC funds.  Any additional losses will be borne by the Federal Reserve through a "non-recourse loan."  The government will provide the guarantee for 10 years for residential mortgage-backed assets and 5 years for commercial assets.

As a "fee" for the guarantee against losses on these assets, Citi will issue $7 billion in preferred stock to the government.  Citi will also issue warrants to purchase 254 million shares of common stock at a strike price of $10.61.  Citi also cannot issue dividends on common shares exceeding one cent for three years.

Another component of the deal is the Treasury's purchase of $20 billion in additional preferred stock, subject to the same terms and conditions of its original $25 billion as part of the Capital Purchase Program.  This $20 billion will come from TARP funds allocated pursuant to the EESA.

In an earlier post about the Capital Purchase Program (here), this blog noted that the government would have a natural inclination to provide further support to financial institutions in which it has already invested.  Whether this is a sign of that phenomenon remains to be seen.  In this instance, the reason for the additional support for Citi was likely because of the sheer size and importance of Citi in the financial markets.  Given how the Lehman bankruptcy froze the credit markets and ground financing to a halt, the government could not afford a further deterioration (of at least the perception -- Citi appears to have been well-capitalized at all times) of Citi's financial condition.

Ambac Lawsuit Seeks To Recoup Losses From Mortgage Securitizer

Ambac Financial Group has recently filed a lawsuit against EMC Mortgage Corp. to recover over $130 million in insurance payments Ambac was forced to make when mortgage-backed securities issued by EMC failed. EMC is a former subsidiary of Bear Stearns, now owned by J.P. Morgan who acquired Bear Stearns when the venerable investment bank failed last year.

According to news reports (here and here), the complaint alleges that “entire pool of loans that EMC securitized in each transaction is plagued by rampant fraud and abdication of sound mortgage-origination and underwriting practices.” Ambac alleges that in one of the mortgage pools it found that 80% of the loans contained misrepresentations with respsect to borrower income, assets, and intentions to occupy purchased properties.

Ambac claims that EMC breached its contractual obligations by failing to repurchase or provide substitute loans so that the securities did not default and require Ambac to pay insurance claims. This could signal a new group of lawsuits in the subprime litigation wave which will determine who will bear the ultimate losses on these securitizations.

FDIC Announces Loan "Mod In A Box" Program

Today the FDIC announced (here) a program for financial institutions that it regulates to utilize the same model it applied at IndyMac Bank after the FDIC took over the failed institution.  The information posted on the FDIC website is meant to contain a "comprehensive package of information to give servicers and financial institutions all of the tools necessary to implement a systematic and streamlined approach to modifying loans."  Under the program, borrowers who are delinquent on their mortgage payments may "receive a loan modification with a maximum 38% down to 31% housing-to-income ratio through the use of interest rate reduction, amortization term extension, and in some cases, principal deferment."

The loan modfication toolkit contains model documents for institutions to use at every step of the process.  It generally involves calculating what the borrower can afford in terms of monthly payment by taking 38% of the borrowers monthly income.  Then, the loan would be modified by a three-step "waterfall" process.  First, the interest rate would be reduced to as low as 3% for at least five years, with it increasing incrementally to the Freddie Mac weekly survey rate in effect at the time of the modification.  If this does not bring the monthly payment down to the affordable level, then the term of the original loan would be extended by 10 years (i.e. a 30 year mortgage would become a 40 year mortgage).  Finally, if this does not yield a low enough monthly payment, the lender would reduce the principal of the loan.  The FDIC also provides a net present value tool to "ensure that the modified payment creates a positive economic scenario for the investor."

The FDIC believes that the loan modification program can be used for virtually any mortgage, whether or not it has been securitized and sold to investors as part of mortgage-backed security.  The FDIC's overview document states that "Loans serviced for private investors are governed by servicing contracts which often contain a standard clause allowing the servicer to modify seriously delinquent or defaulted mortgages, or mortgages where default is 'reasonably foreseeable.'  This even holds true for complex private label securitizations with many tranches and investors."

The role of investors in mortgage backed securities in loan modification programs is currently undefined.  Although the FDIC believes that most servicing agreements would permit loan modification, investors in Countrywide mortgage-backed securities have threatened litigation over Bank of America's (which acquired Countrywide) agreement to modify loans at a potential cost of $8.4 billion in order to settle allegations of predatory lending brought by various state attorneys general.  The investors believe that the agreement improperly shifts these costs to them.  The D&O Diary blog has a great post on this subject (here).

Back On The Hill

The key players in the Bush Administration's financial recovery team - Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernake, and FDIC Chairwoman Sheila Bair - returned to Capital Hill today to brief the House Committee on Financial Services about the efforts under the EESA.

Members of the Committee grilled Mr. Paulson on why more was not being done to stem foreclosures.  Interestingly, there was an open dispute betwee Mr. Paulson and Ms. Bair about that issue.  Mr. Paulson reitereated is opposition to using TARP money to purchase mortgage backed securities or mortgages, the original purpose of the plan, in favor of the changed direction to take direct equity stakes in financial services companies.  He directly opposed Ms. Bair's proposal to use $24.4 billion of the TARP money to modify loans.

Mr. Paulson defended the Capital Purchase Program - now the centerpiece of the use TARP funds - stating that "A lot of it [the capital] still hasn't gone out to the banks. I think we've turned the corner in terms of stabilizing the markets and banks, but we will see restoration to lending" Mr. Paulson said.  Mr. Bernake testified that the credit markets were improving somewhat, but were still "far from normal."  News coverage of the testimony is available here and here. 

Third Circuit Issues Important Truth In Lending Act Decision

In ruling that could be to the benefit of banks, lenders and mortgage servicers, the Third Circuit Court of Appeals ruled last week that the "tolerances for accuracy" provision of the Truth in Lending Act (TILA), 15 U.S.C. Sec. 1605(f), did not have to be alleged as an affirmative defense.  The provision, added to TILA in 1995, excuses creditors from liability under the Act for minor undisclosed finance charges if they are below a specific range.  The case is Sterten v. Option One Mortgage Corporation, No. 07-2237 (available here).

In February 2001, Gayle Sterten obtained a loan from Option One to refinance a second mortgage on her home and consolidate other debts.  Two years after the closing, Sterten wrote Option One claiming that the loan violated TILA and requesting the loan be rescinded. 

Sterten alleged in a lawsuit against Option One, filed as part of Sterten's Chapter 13 bankruptcy, that the finance charges for the loan were not accurately disclosed to her.  Option One answered the complaint with the general denial that it "acted at all times relevant hereto in full compliance with all applicable laws and/or acts," but it did not expressly invoke the "tolerances for accuracy" provision.  The parties later stipulated that ten different fees, totaling roughly $2,000, that were listed on the HUD-1 settlement statement had not been included as a "Finance Charge" disclosed in the TILA disclosure statement.  The bankruptcy judge concluded that the disclosure statement violated TILA because two of the fees -- a $25 "mark up" in the appraisal fee and $32 for notary services -- met the definition of "finance charges."

Option One had not previously defended itself by saying that any undisclosed fees were so minor that they fell within the tolerances for accuracy provision.  However, the trial judge concluded on his own that the undisclosed finance charges were within the tolerance range and therefore the disclosure was "accurate as a matter of law."

Not so fast, said Sterten -- Option One had never raised the tolerances for accuracy provision in its prior pleadings or even at trial.  The trial judge reversed course, and agreed with Ms. Sterten that Option One waived this argument because it failed to specifically assert it earlier.  The court permitted Ms. Sterten to rescind the loan, granted her $2,000 statutory damages and granted her $19,500 in attorneys' fees.

Although the case is important because the Third Circuit decided what a lender had to plead in order to invoke the tolerances for accuracy provision, the actual legal issue centers around the Federal Rules of Civil Procedure, and what is required by Rule 8(c) to be pleaded as an affirmative defense.  The Third Circuit noted that the reason a defendant must plead certain defenses affirmatively, is to prevent unfair surprise to the plaintiff, and that Sterten would not suffer any unfair surprise by allowing Option One to invoke the tolerances for accuracy provision at any time:

We see no reason to think that Sterten suffered any "unfair surprise" as a consequence of Option One's failure to plead specifically the tolerances for accuracy defense.  The analysis a plaintiff must undertake to show any undisclosed finance charges under the Truth in Lending Act -- that there were discrepancies between what was charged and what was disclosed in the Truth in Lending Disclosure Statement, and that those undisclosed fees fall within the Act's definition of a "finance charge" -- is the same analysis required to show that the undisclosed charges exceeded Sec. 1605(f)'s range of error.

Although the court acknowledged that "the most prudent course" was for Option One to argue specifically that if it made any disclosure errors, those errors fell within the tolerance range (which it should be noted goes down to only $35 if a borrower asserting the TILA violation has also been foreclosed on).  However, Option One did not "forfeit" the defense by failing to raise it.  Upon receiving the decision, a deep sigh of relief was heard by Option One (and its lawyers).

Banks' Loan Modification Programs A Byproduct of Capital Purchase Program?

On Monday, Citigroup announced (here) a $20 billion mortgage loan workout program.  This follows on te heals of a similar announcement (here) on November 1 by J.P. Morgan that it would also restructure mortgage loans held by Washington Mutual, which J.P. Morgan acquired when Washington Mutual failed.  Only loans that are owned outright by the banks are typically eligible for the programs.  Each bank is a loan servicer for billions of dollars worth of other loans that are owned by trusts and investors in mortgage backed securities.  Because loan modifications affect the payouts to investors in these securities, investors would likely have to approve modifications of loans for which Citi and J.P. Morgan are servicers rather than owners of the mortgages outright.

Both Citi and J.P. Morgan have stated that these loan modification programs are not the result of government pressure, but instead make good business sense.  Foreclosure, they say, is an expensive way to collect on the loans, particularly because selling repossessed houses in the declining housing market makes it difficult to get decent value on the sale.

Although the banks say it makes good business sense, it is interesting that the announcement of these programs comes on the heels of the banks' participation in the TARP Capital Purchase Program.  Each bank was one of the original nine participants in the program when it was announced.  And last week, the Treasury posted the master securities purchase agreement for the government's investment in these companies.  As set forth in my last post, the securities purchase agreement provides that the participating company will "work diligently, under existing programs, to modify terms of residential mortgages as appropriate to strengthen the health of the U.S. housing market."

It is expected that Fannie and Freddie will announce a similar loan workout plan today, as reported in the Wall Street Journal (here).

With Deadline Looming, Treasury Posts Securities Purchase Agreement For TARP Capital Purchase Program

On Friday October 31st, the Treasury Department released additional information and documents on its website about the TARP Capital Purchase Program for publicly held financial institutions wishing to apply for the capital investment by the government.  A different master agreement will be posted for non-publicly traded entities at a later date.  The deadline for submitting applications is November 14, 2008 for public institutions.  The Treasury's announcement, with links to the various documents, is available here.

The standard purchase agreement is interesting in a number of respects.  Here is my quick summary of some of the various provisions of the agreement.

The Recitals

In the recitals, the financial institution is agreeing to "expand the flow of credit to U.S. consumers and businesses on competitive terms to promote the growth and vitality of the U.S. economy."  This is a reaction to those that have been criticizing the program for allowing participating companies to use the funds to acquire other banks rather than increase lending.

The company also agrees to "work diligently, under existing programs, to modify terms of residential mortgages as appropriate to strengthen the health of the U.S. housing market."

The Bank's Representations and Warranties

Much of the agreement is consumed by the representations and warranties of the participating company.  Most of these appear to be relatively standard, and including representations about the accuracy of the company's financial statements, internal controls, and disclosed liabilities.  However, there also appear to be some unique representations and warranties.  For example, section 2.2(r) specifically addresses "Risk Management Instruments."  This relates to the credit default swaps and other derivatives that have contributed to the financial meltdown (the so-called (by Warren Buffet) financial weapons of mass destruction).  In the provision, the company represents that "all derivative instruments, including, swaps, caps, floors, and option agreements, whether entered into for the Company's own account or the account of one or more of the Company's Subsidiaries or its or their customers, were entered into (i) only in the ordinary course of business; (ii) in accordance with prudent practices and in all material respects with all applicable laws, rules, regulations and regulatory policies; and (iii) with counterparties believed to be financially responsible at the time."  This representation contains language that is ambiguous.  What is a "prudent practice" in the context of the exploding credit default swaps market?  What does it mean that the company believed that its counterparty was "financial responsible at the time"?

Government Access To Company Information

As long as the government is a shareholder, the company agrees to allow access to its books and records and to have its principal managers available to discuss the "affairs, finances, and accounts of the Company" by the Treasury Department or its agents, consultants, contractors and advisors. See Section 3.5.  This could raise concerns with the company in terms of attorney-client privilege and problems with disclosure of sensitive competitive information, particularly where the government has or will be hiring company's in the same industry as contractors.  Section 3.5 attempts to address this situation by providing that the Company does not have to disclose information if it would be "(i) prohibited by applicable law or regulation; or (ii) that such disclosure would be reasonably be expected to cause a violation of any agreement to which the Company or any Company Subsidiary is a party or would cause a risk of loss of privilege to the Company or any Company Subsidiary...."

Executive Compensation

By entering into the agreement, the Company agrees to abide by the executive compensation rules prescribed in Section 111(b) of the EESA and take all steps to amend its executive compensation structure.  The Company must have the senior officers affected by the executive compensation change execute a waiver of his or her right to challenge the change in court.  See Section 4.10; Annex B

Amendment of the Agreement

Although each party must generally agree in writing to any amendment of the securities agreement, the government can unilaterally amend the agreement "to the extent required to comply with any changes after the Signing Date in applicable federal statutes."  See Section 5.3.  This could conceivably leave the company open to changes that a new Congress would like to make to the agreement. 

Waiver Of A Right To A Jury Trial

If there is litigation between the company and its new shareholder related to teh securities agreement, all disputes about the securities agreement will be resolved in the United States District Court for the District of Columbia and the Court of Federal Claims.  The parties agree to waive any right to a jury trial.  Also, the agreement provides that New York law will govern the interpretation of the agreement.